December 14, 2008 / 5:19 PM / 11 years ago

Fed to press rates toward zero

WASHINGTON (Reuters) - The U.S. Federal Reserve is expected to drop interest rates close to zero on Tuesday, but anticipated remarks on unconventional methods to dispel a year-old recession are what will really matter.

Federal Reserve Chairman Ben Bernanke listens to opening statements before testifying before the House Financial Services Committee in a hearing on "Oversight of Implementation of the Emergency Economic Stabilization Act of 2008 and Government Lending and Insurance Facilities; Impact on Economy and Credit Availability" on Capitol Hill in Washington November 18, 2008. REUTERS/Molly Riley

Economists forecast a clear statement that the U.S. central bank will aggressively deploy so-called quantitative easing measures to shelter the economy from a steepening downturn, but do not expect details of what steps it will actually take.

Those words would accompany a decision by the Fed to lower its target for overnight rates by at least a half-percentage point, economists believe.

A half-point cut would take the bellwether federal funds rate to just 0.5 percent, the lowest on records dating to July 1954, as the central bank battles a recession many think will stretch well into next year.

The announcement is expected around 2:15 p.m. on Tuesday at the end of a two-day meeting. The gathering had initially been scheduled for a single day, but was extended so policy-makers could study options for unusual steps to spur the economy with little room left to lower borrowing costs.

“From here on out, monetary policy has to rely primarily on non-traditional tools, tools other than the funds rate, to try to stimulate the economy,” said former Fed Governor Lyle Gramley, who expects the Fed to spell this out.

“They are certainly going to have to acknowledge that non-traditional methods are going to be employed aggressively to try to provide assistance to the economy,” he said.

A U.S. housing collapse panicked credit markets and has hammered the rest of the economy since the failure of investment bank Lehman Brothers in September. Many economists predict economic activity will shrink by an annualized 6 percent or more in the fourth quarter as unemployment climbs.

Quantitative easing, which the Bank of Japan used to end a decade of deflationary stagnation in the 1990s by pumping money into the banking system, was foreshadowed by Fed Chairman Ben Bernanke in a speech on December 1.

He emphasized the Fed would use all the weapons in its arsenal to protect the economy, and identified direct purchases of government and mortgage-related debt as possible options.

TARGET SPREADS

With yields on U.S. government debt already very low and private borrowing rates high because loss-scarred banks are too scared to lend, economists think it more likely the Fed will target private-sector mortgages to drive down home loan costs.

Buying such bonds should narrow the spread between their yields and yields on debt issued by the U.S. Treasury, and allow banks to offer home loans at lower rates.

Lower mortgage rates should raise demand for houses and stem the slide in home prices, which would help staunch massive bank losses that have touched off a global credit crisis.

“My one-word advice to the Fed now is ‘spreads.’ Fortunately, I don’t think Ben Bernanke needs this advice. He gets it,” said Alan Blinder, a former Fed vice chairman and professor of economics at Princeton University.

The Fed has already embarked on quasi-quantitative easing by allowing its balance sheet to more than double in size after pumping over $1 trillion into financial markets to prevent them from seizing up completely in the face of mounting losses.

Such liquidity measures are traditionally “sterilized” so they do not expand the money supply and stoke inflation.

But the Fed has abandoned this practice in an effort to reduce private borrowing costs that have so-far remained elevated despite dramatic official interest rate cuts. In addition, inflation fears have been replaced by worry that prices may fall too far and inflict deflation, similar to the Japanese economic conditions of the 1990s.

“The focus will be on purchasing assets to affect spreads. All of their policies are aimed at driving down borrowing costs to consumers and businesses,” said Dean Maki, co-chief U.S. economist at Barclays Capital in New York.

“We don’t think that the best use of the Fed’s balance sheet is to further reduce the risk-free rate,” he said. U.S. Treasury bonds are said to offer a risk-free rate of return because the U.S. government, with the ability to print dollars via the Federal Reserve, would never default on dollar debts.

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